Module 12 Momentum Indicators & Oscillators Oscillators or Indicators Now we will talk about momentum indicators . The term “momentum” refers to the velocity of a price trend. This indicator measures whether a rising trend is accelerating or decelerating or whether prices are declining at a faster or slower pace. Intraday Momentum Index - IMI . The Intraday Momentum Index (IMI) was developed by Tushar Chande. It is a cross-breed between the RSI and Candlestick Analysis . The calculation of the IMI uses the relationship between the intraday opening and closing prices to determine whether the day is "up" or "down." If the close is above the open, it is an up day. If the close is below the open it is a down day. Therein lies its tie to candlestick charting. For those familiar with Candlestick charting, the IMI separates the black and white candlesticks and performs an RSI calculation on the Candlestick bodies. Relative Strength Index - RSI The Relative Strength Index (RSI) is a popular oscillator used by traders. It was first introduced by J. Welles Wilder in an article in ‘Commodities’ (now known as ‘Futures’) magazine in June, 1978. Step-by-step instructions on calculating and interpreting the RSI are also provided in Mr. Wilder's book, ‘New Concepts in Technical Trading Systems ‘. The name "Relative Strength Index" is slightly misleading as the RSI does not compare the relative strength of two securities, but the internal strength of a single security. A more appropriate name might be "Internal Strength Index." Relative Strength Index - RSI The RSI is a fairly simple formula, but is difficult to explain without pages of examples. The basic formula is: 100 RSI 100 U 1 D U = an average of upward price changes. D = an average of downward price changes. Relative Strength Index - RSI 100 - 100 1+ U/D U=150 D=200 D=120 elative 100% trength ndex 50% Moving Average of RSI (half to two thirds the 0% period of RSI) Rate of Change - ROC . The Price Rate-Of-Change (R.O.C.) indicator (percent method) is calculated by dividing the price change over the last x-periods by the closing price of the security x-periods ago. The result is the percentage that the security's price has changed in the last x- periods . If the security's price is higher today than x-periods ago, the R.O.C. will be a positive number. If the security's price is lower today than x-periods ago, the R.O.C. will be a negative number. Rate of Change - ROC Stochastic Oscillator 100% 90% 90% 100% 75% HHV 50% 20 100% To improve it we calculate a 3 17.5 75% period MA of these percentages we get : 15 50% 96.7% 10 LLV 91.6% 75% C – LLV * 100 %K %D HHV – LLV Stochastic Oscillator The Stochastic Oscillator Technical Indicator compares where a security’s price closed relative to its price range over a given time period. The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called %D, is a Moving Average of %K. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line. Stochastic Oscillator Formula %K = (CLOSE-LOW(%K))/(HIGH(%K)-LOW(%K))*100 Where: CLOSE — is today’s closing price; LOW(%K) — is the lowest low in %K periods; HIGH(%K) — is the highest high in %K periods. %D = SMA(%K, N) Where: N — is the smoothing period SMA — is the Simple Moving Average Oscillator (Indicator) Analysis Analyze in three – Dimensions TREND - Bullish or Bearish AREA - Overbought or Oversold DIVERGENCES - Bullish or Bearish Oscillator Direction Direction – Up & Down Momentum, like prices, move in trends. This means that the techniques used for analysing price trends like using moving averages can be used for appraising momentum trends. We must keep in mind that a trend reversal in momentum is not always associated with a similar reversal in the price. PRICE IS THE BOSS. Oscillator Extremes Area – Overbought & Oversold Markets are essentially driven by psychological forces. Our emotions move from one extreme to another, from greed to fear, from hope to despair. This is what causes momentum indicators to fluctuate from overbought to oversold levels. In a sense, momentum reflects crowd psychology and measures the intensity of the emotions of market participants Psychology – Investor behavior Conviction Enthusiasm Confidence Hope Growing recognition Greed Disbelief Caution Skepticism Apprehension Shock & fear Contempt Surrender Disgust Contrarian Theory A trading theory that recommends making investments contrary to the apparent direction of the market or commonly accepted wisdom. The theory holds that if everyone is certain something is going to happen, then it won't. Contrarians also draw their conviction from the viewpoint that if everyone believes the market will rise, they have already bought. Thus, there are few investors remaining to create additional buying, which means it is likely that the market will decline. Some mutual funds have adopted a contrarian trading strategy as their main focus. So when your grandmother wants to buy… Area – Overbought & Oversold All momentum oscillators move from one extreme to another. Some oscillators, like RSI and IMI are calculated in such a way that they fluctuate between 0% and 100%. In these cases there is an established level for the Overbought and Oversold lines in the above cases 70% and 30% Other oscillators, Like ROC or Momentum do not have maximum or minimum levels so in this case we must calculate the Overbought and Oversold lines ourselves. Oscillator Divergences Divergences– Bullish & Bearish In a nutshell, divergence can be seen by comparing price action and the movement of an indicator. It doesn't really matter what indicator you use. You can use RSI, MACD, ROC, IMI, etc. Just think "higher highs" and "lower lows". If price is making higher highs, the oscillator should also be makin higher highs. If price is making lower lows, the oscillator should also be making lower lows. If they are NOT, that means price and the oscillator are diverging from each other And that's why it's called "divergence.“ divergence is used as a possible sign for a trend reversal Divergences– Bullish If price is making lower lows (LL), but the oscillator is making higher 2 lows (HL), this is considered to be 4 positive ( bullish) divergence. 1 This normally occurs at the end of a down trend. After establishing a 3 5 second bottom, if the oscillator fails to make a new low, it is likely that 2 the price will rise, as price and momentum are normally expected 4 1 to move in line with each other. 5 A divergence is used as a possible 3 sign for a trend reversal Bullish Divergence Divergences– Bearish 5 If the price is making a higher high (HH), but the oscillator is lower high 3 (LH), then you have negative (bearish) divergence. 1 4 This type of divergence can be found in an uptrend After price makes that 2 second high, if the oscillator makes 3 a lower high, then you can probably expect price to reverse and drop. 5 1 A divergence is used as a possible 4 sign for a trend reversal 2 Bearish Divergence Divergences– Bullish & Bearish As you can see from the images above, the divergence is best used when trying to pick tops and bottoms. You are looking for an area where price will stop and reverse. The oscillators signal to us that momentum is starting to shift and even though price has made a higher high (or lower low), chances are that it won't be sustained. A divergence is used as a possible sign for a trend reversal .